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The Supply-Side Gold Standard: A Critique

 

by Frank Shostak 

[Posted June 27, 2002]

[img][/img] According
to"supply-side" economics, the key to economic growth and prosperity
is low marginal tax rates. However, the supply-side school also maintains that a
low marginal tax rate will not be sufficient, that it must be accompanied
by a monetary policy that aims at achieving price stability. The pillar of the
proposed monetary policy is a gold-price rule, where the central bank targets
the dollar gold price at a specified figure.

Let us say that the Fed has concluded that the"correct"
target must be $350 per ounce of gold. If the price of gold falls to below $350
per ounce, this is indicative of growing demand for money, which the Fed then
must accommodate through open market purchases of government securities, i.e.,
an injection of money into the economy. As a result of this injection, the price
of gold will go up.

Conversely, if the price of gold rises above $350 an ounce, it
means that people's demand for money has fallen and that the central bank must
take money out of the system. By selling government securities, money will be
taken out of the system. This, in turn, will exert downward pressure on the
price of gold.

Observe that, for supply-side proponents, gold is not money
but rather an instrument to stabilize the present paper standard. The chief role
of money within this framework of thinking is that money fulfills the role of a
unit of account. Since it is imperative that this unit must remain stable in
order to fulfill this role, supply-siders hold that anchoring the dollar to gold
will do the trick. This, in turn, will make the dollar as good as gold. 

But is the definition of money as predominantly a unit of
account valid? 

<h1>Defining money</h1>

The purpose of a definition is to present the essence--the
distinguishing characteristic of the subject we are trying to identify. A
definition aims at telling us what the fundamentals of a particular entity are.

To establish a definition of money, we have to ascertain how
the money economy came about. Money emerged because barter could not support the
market economy. A butcher who wanted to exchange his meat for fruit might not
have been able to find a fruit farmer who wanted his meat, while the fruit
farmer who wanted to exchange his fruit for shoes might not have been able to
find a shoemaker who wanted his fruit.

The distinguishing characteristic of money is that it is the
general medium of exchange. It has evolved from the most marketable commodity.
On this Mises wrote,

There would be an inevitable tendency for the less marketable
of the series of goods used as media of exchange to be one by one rejected
until at last only a single commodity remained. Which was universally employed
as a medium of exchange; in a word money.<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn1" name="_ftnref1">[1]</a>

Since the general medium of exchange emerged from a wide range
of commodities, money must be such a commodity.

Consequently, according to Rothbard,

Money is not an abstract unit of account, divorceable from a
concrete good; it is not a useless token only good for exchanging; it is not a
claim on society; it is not a guarantee of a fixed price level. It is simply a
commodity.<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn2" name="_ftnref2">[2]</a>

Moreover,"an object cannot be used as money unless, at
the moment when its use as money begins, it already possesses an objective
exchange value based on some other use" ( Mises 1980, p. 131).

Why?

In contrast to directly used consumers or producers goods,
money must have pre-existing prices on which to ground a demand. But the only
way this can happen is by beginning with a useful commodity under barter, and
then adding demand for a medium to the previous demand for direct use (e.g.,
for ornaments, in the case of gold). (Rothbard 1981, pp. 3-4).

In short, money is that for which all other goods and services
are traded. This fundamental characteristic of money must be contrasted with
those of other goods. For instance, food supplies the necessary energy to human
beings, while capital goods permit the expansion of infrastructure that in turn
permits the production of a larger quantity of goods and services.

In its capacity, money also fulfills the role of the medium of
savings, the role of a unit of account, and a store of value. The fundamental
role--the essence--of money, however, is that of a general medium of exchange.
Because of this, all other functions of money emerge. In short, the fact that a
good becomes the medium of exchange gives rise to these other functions.

<h1>Is there a need to accommodate the demand for money?</h1>

When we talk about demand for money, what we really mean is
the demand for money's purchasing power. After all, people don't want a greater
amount of money in their pockets so much as they want greater purchasing power
in their possession.

On this Mises wrote,

The services money renders are conditioned by the height of its
purchasing power. Nobody wants to have in his cash holding a definite number
of pieces of money or a definite weight of money; he wants to keep a cash
holding of a definite amount of purchasing power.<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn3" name="_ftnref3">[3]</a>

In a free market, in similarity to other goods, the price of
money is determined by supply and demand. Consequently, if there is less money,
its exchange value increases. Conversely, the exchange value falls when there is
more money. In short, within the framework of a free market, there can be no
such thing as"too little" or"too much" money. As long as
the market is allowed to clear, no shortage of money can emerge.

Consequently, once the market has chosen a particular
commodity as money, the given stock of this commodity will always be sufficient
to secure the services that money provides. Hence, in a free market, the whole
idea of managing the supply of money in line with changes in the demand for
money as suggested by the proponents of supply-side economics is absurd.

According to Mises:

As the operation of the market tends to determine the final
state of money's purchasing power at a height at which the supply of and the
demand for money coincide, there can never be an excess or deficiency of money.
Each individual and all individuals together always enjoy fully the advantages
which they can derive from indirect exchange and the use of money, no matter
whether the total quantity of money is great, or small.... the services
which money renders can be neither improved nor repaired by changing the
supply of money.... The quantity of money available in the whole economy is
always sufficient to secure for everybody all that money does and can do.<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn4" name="_ftnref4">[4]</a> 

But how can we be sure that the supply of a selected commodity
as money will not start to rapidly expand on account of unforeseen events? Would
that not undermine people's well-being? If this were to happen, then people
would probably abandon this commodity and settle on some other commodity.
Individuals, who strive to preserve their life and well-being, will not choose a
commodity that is subject to a steady decline in its purchasing power as money.

This is the essence of the market-selection process and the
reason why it took several thousands years for gold to be selected as the most
marketable commodity. In short, the prolonged market-selection process raises
the likelihood that gold is the most suitable commodity to fulfill the role of
money.

Furthermore, the accommodation of rising demand through the
expansion of money supply will in fact achieve contrary results, because people
do not want more money but more purchasing power. However, raising the supply of
money will dilute its purchasing power and thereby deny people's wishes. It is
like suggesting that because the demand for the Mona Lisa painting has gone up,
we ought to lift the supply by producing counterfeit paintings.

<h1>"Dollar" not an independent entity</h1>

Since in a true free-market economy, money is gold, there is
no such thing as an independent entity such as a"dollar." Prior to
1933, the name"dollar" was used to refer to a unit of gold that had a
weight of 23.22 grains. Since there are 480 grains in one ounce, this means that
the name dollar also stood for 0.048 ounce of gold. This in turn, means that one
ounce of gold referred to $20.67. Now, $20.67 is not the
price of one ounce of gold in terms of dollars as popular thinking has it, for
there is no such entity as a dollar. Dollar is just a name for 0.048
ounce of gold. On this Rothbard wrote,

No one prints dollars on the purely free market because there
are, in fact, no dollars; there are only commodities, such as wheat, cars, and
gold.<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn5" name="_ftnref5">[5]</a>

Likewise, the names of other currencies stood for a fixed
amount of gold. The habit of regarding these names as a separate entity from
gold emerged with the enforcement of the paper standard. Over time, as paper
money assumed a life of its own, it became acceptable to set the price of gold
in terms of dollars, francs, pounds, etc. The absurdity of all this reached new
heights with the introduction of the floating currency system.

In a free market, currencies do not float against each other.
They are exchanged in accordance with a fixed definition. If the British pound
stands for 0.25 of an ounce of gold and the dollar stands for 0.05 ounce of gold,
then one British pound will be exchanged for five dollars. This exchange stems
from the fact that 0.25 of an ounce is five times larger than 0.05 of an ounce,
and this is what the exchange of 5-to-1 means.

The absurdity of a floating currency system is no different
from the idea of having a fluctuating market price for dollars in terms of cents.
How many cents equal one dollar is not something that is subject to fluctuations.
It is fixed forever by definition<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn6" name="_ftnref6">[6]</a>.

In a free market, therefore, the meaning of the gold standard
is that gold is money. Contrast this with the supply-side framework, which views
gold as separate from the dollar. Curiously, supply-siders call the scheme a
"gold standard," which is, of course, erroneous. 

Once it is realized that in a free market the name dollar
stands for a fixed weight of gold, it will obviously be preposterous to
contemplate the gold-price rule as suggested by the supply-siders. 

Furthermore, once it is realized that money is a commodity, it
is obvious that, in similarity to other goods and services, its exchange value
cannot stay still but will vary in accordance with the supply and demand of gold
and supply and demand of other goods and services. Any attempt to stabilize
prices amounts to stifling the operation of the market economy and results in
the misallocation of resources and economic impoverishment.

<h1>Gold-price rule: Recipe for boom-bust cycles</h1>

According to supply-siders, the major factor behind boom-bust
cycles is not the Federal Reserve but the high marginal tax rate. For instance,
in his various writings--including the book The Way the World Works--J.
Wanniski regards a high tax rate as the cause of boom-bust cycles. According to
Wanniski, the monetary policy of the Fed has very little to do with boom-bust
cycles. In fact, in
a note he wrote,"But first, the Fed (and the gold standard) needs to
be absolved of guilt for the 1930s. The Great Depression was caused by rising
tariffs and taxes worldwide…"

The problem with all this is a failure to define what
boom-bust cycles are all about. The distinguishing characteristic of a
successful producer is his ability to"read the market correctly" and
thereby establish a profitable production structure. It is in the interest of
every businessman to secure a price where the quantity of goods that is produced
can be sold at a profit. In setting this price, a producer/entrepreneur will
have to consider how much money consumers are likely to spend on the product. He
will have to consider the prices of various competitive products. He will also
have to consider his production costs.

A producer must also pay attention to likely movements in
interest rates. By complying with market prices and interest rates, the producer
is said to be"in tune" with reality. Whenever he misjudges future
prices and interest rates, he is said to be"out of sync" with market
conditions, and he suffers losses.

A major factor that distorts producers’ judgments regarding
the true conditions of the market is the central bank’s easy monetary policy.
This policy leads to an artificial lowering of interest rates and thereby
falsifies an important market signpost that producers pay attention to.
Consequently, this triggers activities that are out of touch with reality; an
economic"boom" is set in motion.

The central bank’s easy monetary policy causes producers to
make business errors. Once the central bank tightens its monetary stance,
however, the facts of reality are revealed, various activities that sprang up on
the back of previous loose monetary policies are abandoned, and an economic bust
emerges. >>From this we can infer that a recession is: a process
whereby business errors brought about by past easy monetary policies are
revealed and liquidated once the central bank tightens its monetary stance. 

This definition of a recession--a business-error liquidation
process--informs us that the driving force behind boom-bust cycles is central
bank monetary policies.

This definition of a recession embraces not only
"ordinary" recessions but also depressions. The only difference
between a recession and a depression is the extent of business errors. In other
words, the longer the boom, all else equal, the more severe
the bust is going to be. Furthermore, the severity of the slump is affected
by the state of the real pool of funding. A growing pool of funding--savings and
capital stored up to make future production possible--will make the business
error adjustment process easy to handle. Conversely, a stagnant or a declining
pool will make the adjustment process more painful.

While a growing government and hence higher taxes will weaken
the real pool of funding, which in turn will prolong the recession, they don’t
of themselves set in motion boom-bust cycles as such. In order to provide an
explanation of a bust, one must present a theory of a boom. But how can rises in
taxes by themselves explain the phenomenon of a boom, which is accompanied by a
general rise in prices? Without the increase in money supply, no boom and
general rise in prices can emerge. Moreover, if, according to Wanniski, the
Great Depression continued for a decade solely because of high taxes, then why
didn’t we have a permanent depression from World War Two, since tax rates have
been much higher since then?<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn7" name="_ftnref7">[7]</a>

Obviously, then, if the Fed were to follow the
supply-siders’ dollar-gold rule, it would not eliminate boom-bust cycles.
Thus, whenever the price of gold fell below the nominated $350-an-ounce level,
the Fed would pump money thereby setting in motion an economic boom. Once the
price of the yellow metal rose above the $350 an ounce, the Fed would tighten
its stance thereby setting in motion an economic bust.

Observe that the boom and the bust are set in motion
regardless of the demand for money. Thus when the Fed pumps more money in
response to the lower gold price, the rise in the demand for money cannot
neutralize the effect of the expansion in the money stock. In short, the newly
injected money will always cause damage to the real economy by setting an
exchange of nothing for something, or consumption not supported by production.

Those of the supply-side movement like to project themselves
in the image of free-marketers and in opposition to government interference. Yet
their entire approach runs contrary to the spirit of a free market. In fact,
they are very much like the rest of mainstream economics. While mainstream
economists advocate the management of demand, supply-siders advocate the
management of supply. It is even argued that, in order to promote greater
production, there must be a preference for taxing consumption rather than
production. According to Raymond J Keating,"In addition, supply-side
recognition that supply comes before demand in the economic order leads to a
preference for taxing consumption rather than production."<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftn8" name="_ftnref8">[8]</a>

In the free-market economy, neither demand nor supply is
managed. Both consumption and production are equally important in the
fulfillment of people’s ultimate goal, which is the maintenance of life and
well-being. In short, consumption is dependent on production, while production
is dependent on consumption. The loose monetary policy of the central bank
breaks this unity by creating an environment where it appears that it is
possible to consume without production. This unity can be restored by bringing
back the market-selected money: gold.

<h1>Conclusion</h1>

The belief that the present unstable financial system can be
cured by means of a monetary policy that targets the price of gold is erroneous.
This framework, which is offered by the supply-side-economics movement, is
likely to further destabilize the economy. What supply-siders are advocating is
the replacement of one form of government monetary control with another form of
control--erroneously believing that their form of money manipulation will
achieve economic prosperity. What is needed, then, is not a reversion to the
bankrupt Bretton Woods system, as is suggested by supply-siders, but a genuine
gold standard where gold is money.

<hr align="left" width="33%" SIZE="1">

Frank Shostak is an adjunct scholar of the Mises Institute and
a frequent contributor to Mises.org. Send him MAIL and
see his outstanding Mises.org Articles
Archive. Dr. Shostak expresses gratitude to Michael Ryan for helpful
comments during the writing of this article. See also Walter
Block on Mundell, Ludwig von
Mises on Gold versus Paper, and Murray
Rothbard's What Has Government Done to Our Money.

<hr align="left" width="33%" SIZE="1">
<div>
<div id="ftn1">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref1" name="_ftn1">[1]</a> Mises,
Ludwig von, 1980, The Theory of Money and Credit. (Indianapolis,
Ind.: Liberty Classics), p. 45.

</div>
<div id="ftn2">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref2" name="_ftn2">[2]</a> Rothbard
, Murray N., 1981, What Has Government Done to Our Money? (Novato,
Calif.: Libertarians Publishers), p. 4.

</div>
<div id="ftn3">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref3" name="_ftn3">[3]</a> Mises
Ludwig von, Human Action, 3rd revised edition (Chicago:
Contemporary Books, 1966), p. 421.

</div>
<div id="ftn4">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref4" name="_ftn4">[4]</a> Ibid.

</div>
<div id="ftn5">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref5" name="_ftn5">[5]</a> Murray
N. Rothbard"The Case for a Genuine Gold Dollar," in Llewellyn
H. Rockwell, Jr., The Gold Standard: An Austrian Perspective (Lexington,
Mass: D.C. Heath, 1985), pp. 1-17.

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref6" name="_ftn6">[6]</a> Ibid.

</div>
<div id="ftn6">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref7" name="_ftn7">[7]</a> Rothbard,
Murray unpublished memo,"Review of Jude Wanniski, 'The Way The World
Works,'" (Historical Parts), April 6, 1980.

</div>
<div id="ftn8">

<a title href="http://www.mises.org/fullstory.asp?control=991&FS=The+Supply%2DSide+Gold+Standard%3A+A+Critique#_ftnref8" name="_ftn8">[8]</a> Keating,
Raymond, Understanding Supply-Side Economics: The Principles, the
Policies, and the Future (Washington, D.C.: Small Business Survival
Committee’s 21st  Century Small Business Policy
Series, May 2001), p. 6.

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